U.S. Securities & Exchange CommissionDivision of Enforcement The U.S. Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. Views expressed herein are those of the presenter and do not necessarily reflect the views of the Commission or other members of the staff of the Commission.
Today’s Topic • Financial Reporting and Issuer Disclosure • Focus on Financial Fraud
Financial Fraud is: • “… Intentional or reckless conduct, whether act or omission, that results in materially misleading financial statements…” • “… it may entail gross and deliberate distortion of corporate records, … falsified transactions, … [or] the misapplication of accounting principles.” • Report of the National Commission on Fraudulent Financial Reporting; COSO, October 1987
Fraud is Different than Errors • “Fraudulent financial reporting differs from other causes of materially misleading financial statements, such as unintentional errors.” • Report of the National Commission on Fraudulent Financial Reporting; COSO, October 1987
Three Conditions are Usually Present: • Management has an incentive or is under pressure • The opportunity exists for a fraud to be perpetrated • The fraudsters rationalize their fraudulent acts • Statement on Auditing Standards 99, October 2002
Answer: • Starts with “making the numbers” • Then, “Managing the Numbers” • Ends with “making up the numbers”
Rationalization includes: • “We need to make our projections…” • “I’m getting pressure from the boss…” • “We need to meet Street expectations…” • “Our acquisition will fall through if we don’t…”
And, Let’s Not Forget the Popular “We’ll make it up next quarter…”
But, even a simple mistake can be turned into a financial fraud through “cover-up” efforts.
Annual Caseload by Fiscal Year Between 450 and 600 new cases each year
SEC Enforcement: FY 2002 • 598 total cases • Largest categories: • Financial fraud and issuer reporting (27%) • Offering fraud (20%) • Broker-dealer (14%) • Insider trading (10%) • Market manipulation (7%) • Investment adviser/company (8%)
Financial Reporting and Issuer Disclosure: Actions Filed • 163 actions filed in FY 2002 • Compared to: • 112 in FY 2001 • 103 in FY 2000 • 94 in FY 1999 • 79 in FY 1998
Sources of Cases • Other Agencies • Self-Reporting • Auditor Reports • Informants
Complaint Center • 500-800 complaints a week • Many concern financial misconduct • www.sec.gov
Commission Top Priority • October 17, 2001: “Financial fraud and reporting cases are our top priority” • FY 2002 – 216 New financial fraud and reporting investigations opened • 69% increase over FY 2001
Resources • 970 Staff Members • 2500+ Open Investigations • Half of resources on financial fraud
Common Fraud Schemes • Premature revenue recognition • Excess reserves to smooth earnings • Improper capitalized costs • Changing estimates “to make the numbers” • Top-Side Journal Entries • “Earnings Management”
Backdating of contracts Fictitious invoices Shipment of unfinished product Revenue after the fiscal period Revenue recognized on products not shipped or not yet manufactured Hidden “side letters” giving customers rights to return product Traditional Fraudulent Revenue Schemes
New Types of Cases • Looting • SPE’s • Related party transactions • Undisclosed compensation • Misleading “Pro Forma” releases • Round-tripping • Accommodations • Channel stuffing • Acceleration of revenue in multiple-element arrangements
Growth in Enforcement Investigations • In 1998, we had 1733 investigations • In 2002, we had 2402 investigations • 39% increase in investigations
Growth in Financial Fraud Actions • In 1998, we brought 79 financial fraud/reporting actions • In 2002, we brought 163 financial fraud/reporting actions • 106% growth in financial fraud actions
Growth in Actions Involving Fortune 500 Companies • In 1998, 4 of the 79 financial fraud actions (5%) involved Fortune 500 companies • In 2002, 29 of the 163 financial fraud actions (18%) involved Fortune 500 companies • 625% growth
Actions Brought in the Last 12 Months • Michael Kopper and Andrew Fastow (Enron) • WorldCom • RiteAid and its senior management • Adelphia Communications and its senior management • Microsoft • Senior management of Waste Management • Amazon.com • Xerox
Still More • PricewaterhouseCoopers • Ernst & Young • Top officers of Tyco • Homestore.com officers • Dynegy • KPMG • HealthSouth
FINANCIAL REPORTING AND ISSUER DISCLOSURE: Themes and Trends
Financial Reporting & Issuer Disclosure: Themes and Trends • Coordination with criminal authorities
Close Cooperation with Prosecutors • Corporate Fraud Task Force • US Attorneys want the cases • State authorities want the cases • Plenty of cases to go around
Criminal Cases –FY 2002 • 17 Federal districts brought criminal securities fraud cases • More than 259 people and entities charged
Enron • Michael J. Kopper held various executive positions at Enron, most of the time reporting directly to Andrew Fastow, Enron’s CFO. • In August 2002, the Commission filed a settled action against Kopper in which he agreed to disgorge and forfeit $12 million, to be permanently enjoined from violating the federal securities laws, and to be barred from acting as an officer or director of public companies. • On the same day, Kopper pleaded guilty to conspiracy to commit wire fraud and money laundering, agreed to forfeit $4 million (included in the $12 million above), and to cooperate with the government's continuing investigation.
Enron • Commission filed enforcement action against Andrew Fastow, former CFO of Enron, alleging violations of anti-fraud, periodic reporting, books and records, and internal controls provisions of federal securities laws. • Commission seeks disgorgement of all ill-gotten gains, including all compensation received subsequent to commencement of the alleged fraud, civil money penalties, a permanent bar from acting as a director or officer of a public company, and an injunction from future violations of the federal securities laws. • Commission brought action in coordination with DOJ’s Enron Task Force, which filed a related criminal complaint against Fastow.
Enron • Commission complaint alleges: • Fastow involved with three transactions -- RADR, Chewco, and Southampton – that were part of an alleged scheme to hide his and Michael Kopper's interest in and control of certain entities in order to keep those entities off Enron's balance sheet. • Fastow secretly nominated certain of the owners of these three entities, funded certain of their investments through undisclosed loans, collected undisclosed fees, and demanded and received under-the-table payments, including payments to himself and his family members disguised as yearly $10,000 non-taxable gifts. • Purpose of scheme was self-enrichment and to mislead analysts, rating agencies, and others about Enron's true financial condition.
Enron • Commission complaint further alleges: • Fastow participated in two additional transactions that were essentially sham sales - best described as secret asset-parking arrangements. • Fastow and others backdated documents to avoid diminution in Enron's investment in the stock of a technology company. Specifically, Fastow and others created documents that purported to lock in the value of Enron's investment in that company back in August of 2000, when that company's stock was trading at its all-time high price. • Throughout the period of his alleged fraudulent conduct, Fastow sold millions of dollars worth of Enron securities.
Adelphia Communications • Commission filed charges against Adelphia, its founder (John J. Rigas), his three sons, and two other senior executives, alleging one of the most extensive financial frauds ever to take place at a public company. • US Attorney for SDNY filed related criminal charges against several of the same defendants. • Commission’s investigation is continuing.
Adelphia Communications • SEC complaint alleges that Adelphia, at the direction of the individual defendants: • Fraudulently excluded billions of dollars in liabilities from its consolidated financial statements by hiding them on the books of off-balance sheet affiliates; • Falsified operations statistics and inflated earnings; and • Concealed rampant self-dealing by the Rigas Family, including the undisclosed use of corporate funds for Rigas Family stock purchases and the acquisition of luxury condominiums.
Adelphia Communications • The Commission is seeking: • Officer and Director bars • Disgorgement of all ill-gotten gains, including: • Compensation received during the fraud • Property unlawfully taken from Adelphia through undisclosed related-party transactions • Severance payments • Permanent anti-fraud injunctions • Civil penalties from each defendant, including Adelphia. • Penalty against company sought because Adelphia failed early on to cooperate with the Commission's investigation and actually allowed the fraud to continue until the Rigas family lost control over the company's conduct.
Financial Reporting & Issuer Disclosure: Themes and Trends • Coordination with criminal authorities • Emphasis on personal accountability • Greater use of O&D bars • Disgorgement of compensation
Officer and Director Bars Officer and Director bars sought in all categories of cases: • FY 2002: 126 • FY 2001: 51 • FY 2000: 38
Rite Aid • Former CEO, CFO, Vice Chairman charged with fraud in connection with wide-ranging accounting fraud scheme that enabled the company to overstate its income in every quarter from May 1997 to May 1999. • Former CEO also charged with engaging in undisclosed related-party transactions and fabricating Board minutes to facilitate the fraud. • Commission is seeking: • Fraud injunctions • Officer & Director bars • Disgorgement of bonuses • Civil penalties
Rite Aid • Commission also brought settled cease and desist proceedings against the company for reporting and books-and-records violations, and against the former COO for fraud and causing the company’s violations. • Rite Aid cooperated in the investigation, including declining to assert its attorney-client privilege and voluntarily providing Commission staff with full access to an internal investigation conducted by Rite Aid's counsel. • The value of this cooperation was considered in determining the appropriate resolution of this matter. • Parallel criminal charges were filed against the three former officers and directors.